October 06, 2014 - A key challenge for today's gas business in Europe is chronic market oversupply with virtual gas on the hubs causing price imbalances that could be mitigated by adjusting existing long-term contracts, Sergei Komlev, head of Gazprom Export's contract structuring and price formation department, responsible for market analysis, told Platts in an interview last week.

"Paradoxically, gas price erosion is taking place at a time when physical supplies are tight," Komlev said, adding that some European market analysts had acknowledged that hubs were overflowing with largely "paper" gas.

This became possible with the development of the spot gas market as hubs developed a new class of customer such as banks and commodity traders, Komlev said.

"When some time ago our clients sold our contract volumes on a forward curve for many months ahead they targeted this new class of customers first," he said.

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But "as no one is in a position to predict the weather, traded volumes of 'paper' gas significantly surpassed real world demand for gas because of the abnormally warm winter in 2014," he said.

This artificial oversupply had put significant pressure on the market, resulting in a collapse in spot prices, he said.

"As a result, our European customers are facing negative margins as they have to supply gas to end-consumers at lower prices than they pay for physical deliveries under long-term contracts," he said.

Komlev stressed that "under the previous system, oversupply could not happen because our clients ordered as much gas from Gazprom as was nominated by their own customers."

Long-term contracts were shaped at a time when spot gas markets in Europe were not developed, and the gas price -- linked to oil prices -- "was practically independent of supply/demand dynamics," Komlev said.

In such an environment, the flexibility in contracted volumes which long-term contracts provided did not a negative impact on the system, Komlevsaid.

As market conditions have changed and European partners are pushing for a greater role for spot prices in long-term contracts, it is time for Gazprom to tighten up its contracts with European partners to secure its interests as a supplier, Komlev said.

In his view, this could be achieved through expanding a take-or-pay clauses to 100% of contracted volumes combined with a cut in contracted volumes.

Currently, supply contracts "provide huge flexibility to our customers" allowing them to increase imported volumes but because of overcontraction this was having a bearish impact on wholesale prices, he said.

"In such a situation, we are minded to eliminate the flexibility of contracts, with a possible cut in volumes, if we're moving closer to the spot price because otherwise we're putting ourselves at a disadvantage because we're offering a more expensive product" at the price of a lower-value commodity, he said.

Gas supplied under long-term contracts includes a premium for security of supply and flexibility, including seasonal flexibility, in comparison with a commodity bought at a hub, he said.

Komlev reiterated that Gazprom remained a key gas supplier to Europe, while gas deliveries from other sources to European gas markets were falling, European production shrinking and LNG was being redirected to other markets.

Gazprom's deliveries to Europe rose 16% year on year in 2013, and "despite a fall in [European gas] demand of 20% in the first half of 2014, our deliveries will rise compared with last year, while all other suppliers are expected to cut their deliveries further -- similar to what happened last year," Komlev said.

Price talks

Asked about the renegotiation of prices between Gazprom and its European clients under existing contracts, Komlev said Gazprom was currently discussing the issue with "a wide range of companies" but declined to name any.

He added however that Gazprom's position was that "oil indexes should remain" and the changes represented "a sort of compromise which envisages different tools to bring contracted prices [closer to the level of] spot prices to mitigate the difference."

"But at the moment the room for compromise has been fully exploited," he said, and the changes "do not provide any serious, pivotal solution as they lead to the erosion of export prices, something we cannot agree to."

A combination of high oil-indexed contract prices and lower spot hub prices has caused many European gas companies to renegotiate their contracts with Gazprom in recent years.

Gas dispute with Ukraine

Separately, Gazprom was continuing to take measures to mitigate possible risks to stability of Russian gas exports to Europe because of the dispute with key transit country, Ukraine, over gas prices and debt, Komlev said.

The situation was much better now than it was in 2009 when a similar dispute between Gazprom and Naftogaz Ukrayiny resulted in a halt to gas deliveries to Europe for more than two weeks in January, he said.

Firstly, because there was an alternative route for direct supplies via the Nord Stream gas pipeline across the Baltic Sea, and an increased capacity on the Yamal-Europe pipeline via Belarus and Poland to Germany, he said.

In addition, both Europe and Russia were actively injecting gas into storage facilities for use during the peak-demand season.

Gas storage in key European countries has already been filled to around 95-99% of capacity, as of September 30, according to Gas Storage Europe.

In Russia, Gazprom is also actively pumping more gas into its storage facilities, with a view to using it for additional supplies to Europe if there is disruption to transit via Ukraine.

Pumping gas from Russian facilities would allow reducing shipping time to Europe in the event of increased demand, Komlev said.

Deliveries to Europe from Russian storage facilities would take around three days against around a week for deliveries from Russian fields in West Siberia, he said.

CEO Alexei Miller has said that the capacity of the alternative routes would not allow Gazprom to offset fully potential losses in gas deliveries to Europe if transit via Ukraine were stopped.

Gazprom has repeatedly said that it does not plan to stop transit via Ukraine but there are concerns that Kiev might decide to withdraw gas destined for Europe for its own needs in cold season, as has happened in the past.

Gazprom stopped supplies to Ukraine in mid-June after Ukraine refused to pay for gas delivered in late 2013 and the first half of 2014, demanding price renegotiation first.

Expectations are high that the parties will reach a compromise that would allow gas supplies to and via Ukraine during the winter, with the next round of talks between Russia, Kiev and the EU scheduled for this week.